Michael J. Blanchard asked:
Are All Executives Above Average?
How performance-based incentive plans reward
achievement within the banking industry
by Michael J. Blanchard
How do we fairly compensate top executives and key officers in this era of corporate governance and legislative change? This is a common question for the board of directors at many banks across the country. As financial institutions try to maximize profitability, they must perform a tricky balancing act: manage payroll expenses while trying to attract and retain qualified staff and management. Many are finding that incentive compensation plans are the key to producing a win-win scenario.
Because they reward and recognize contributions of high-performing employees—and help drive the overall success of the organization—incentive plans are becoming increasingly common in the banking industry: Employed by 45 percent of banks under $100 million, that figure rises to 90 percent or more for banks with assets of $500 million and above (see sidebar). However, designing and implementing a plan does not ensure its long-term effectiveness. Existing incentive plans must be assessed against the bank’s strategic plan, as well as market trends, on a periodic basis.
This article will discuss initial plan design and documentation, as well as how to diagnose and solve problems that may have evolved with a once-effective incentive plan. Our goal is to help you ensure that your bank’s incentive plans continue to reward executives and key officers for their achievements, while driving shareholder value.
Pay-for-Performance Compensation Uses Objective Measures to Reward Achievement
A “pay-for-performance†strategy is one that links employee pay to the achievement of predetermined performance goals. This strategy uses objective measures to reward executives and key officers for quality performance. The most common approach for an executive incentive plan is to provide graduated levels of compensation for attaining overall bank objectives such as EPS (earnings per share), ROE (return on equity), ROA (return on assets) and/or Asset Growth. For example, if ROE reaches the agreed-upon target level, executives receive a pre-determined incentive payment. Under a pay-for-performance plan, this incentive payment typically increases as ROE increases above the target.
Why Incentive Plans Must Become More Sophisticated
Initially, as incentive plans became popular in the banking industry, the most common payout structure utilized a pooled approach, typically based on a percentage of annual bank profitability (net income). For example, a bank might take 5 percent to 10 percent of the annual profits and distribute the “bonus pool†to the senior management team. Some banks allow the CEO to allocate a portion of the pool to senior management and other key officers on a discretionary basis, while other banks distribute the amount proportionately to all officers.
But organizations have found drawbacks in traditional pooled-approach incentive plans. Despite the performance-based foundation, these plans do not differentiate the bank’s superstars from its underachievers. In addition, the payouts from these types of plans are often viewed by the recipients as “mystery money†because participants are not sure how the payouts were calculated or earned. This perception tends to be more prevalent among mid-management and staff-level employees. Even worse, when incentives are received on a regular basis without communication as to how the payouts are calculated, participants may feel entitled to receive the payment each year regardless of performance.
Multiple-Component Approaches can Incorporate Individual, Department and Bank Goals
To address these issues, many high-performance banks now incorporate both department and individual criteria into the incentive payout calculations for key officers of the bank.
For example, the CLO may be measured against non-accruals as well as new loans added, or the COO may be measured against non-interest expense ratios. When multiple variables are used, weight-factors are assigned to each variable to calculate incentive payouts. Weight-factors are determined by how much impact the executive’s performance may have on the variable.
This matrixed approach allows the bank to reward plan participants for meeting or exceeding goals that are within their control. The figure below illustrates this multiple-component, pay-for-performance methodology.
Formalizing and Documenting the Annual Incentive Plan
As a bank grows and adds more participants to pay-for-performance programs, it becomes necessary to document a formal annual incentive plan. The annual incentive plan document will then serve as an effective tool for helping the board, senior management and human resources administer the plan. The document also can be used to communicate the quantitative methodology for distribution of incentive payouts. This helps remove perceptions that “management is playing favorites†or that bonus payouts are “mystery money.â€
Macro Forces to Consider When Designing and Implementing Annual Incentive Plans
As pay-for-performance compensation programs are becoming more prevalent in the banking industry, both senior management and the board of directors need to be aware of recent trends and legislative events that impact annual incentive programs. These include:
High demand for commercial lenders: The demand for high-quality commercial lenders in the banking industry is at an all-time high. Due to this demand, the incentive payout for these key officers has come under much scrutiny. Because these officers are demanding high-incentive compensation to reward performance, the bank must ensure that it is compensating performance that is linked to the strategic direction of the bank. For example, commission-based programs may be effective for large banks that focus on gaining market share. However, for small- to mid-size banks may do better to compensate the officer using a multi-criteria incentive payout program with a market-competitive base salary. This allows officers to attain above-market cash compensation (salary + bonus) if they achieve loan-growth goals, department goals (cross-selling and deposit growth), and overall bank goals (ROE, net income). Incorporating overall bank goals promotes cross-selling and encourages teamwork among departments. This type of multi-component approach focuses on overall bank performance, countering the “every man for himself†attitude that often accompanies commission-based programs.
Annual incentive deferrals and the American Jobs Creation Act: According to a Clark Consulting analysis, approximately one-third of publicly traded financial institutions offer a voluntary deferral program to their executive officers. The tax-deferred benefit of a voluntary deferral is still a valid compensation vehicle for executive officers. However, participation is limited to “top-hat†employees (top 10 percent of the organization). In addition, any voluntary deferral program must comply with the American Jobs Creation Act of 2004, which limits the accessibility of deferred compensation. If the plan does not comply with the act, both the bank and the individual will suffer severe tax penalties.
Integration with compensation philosophy: Many banks are choosing to develop a formal compensation philosophy statement that guides future compensation decisions. Typically, a compensation philosophy identifies who participates in the incentive compensation program and how much incentive-earning opportunity is available compared to market research. For example, the compensation philosophy may state that the bank will target base salary at the 50th percentile or market median, while the annual i
ncentive payout will be designed to allow the employee to increase cash compensation (base salary + bonus) to the upper quartile (75th
percentile) or higher, if both the bank and the individual exceed performance expectations.